Can Lucent Find the Light?

October 22, 2002

By Olga Kharif No one knows better than CEO Patricia Russo that it's time for emergency measures at Lucent Technologies. That was painfully clear on Oct. 23, when Lucent revealed to Wall Street just how bad the latest quarter's results were. In the period ended Sept. 30, Lucent posted a loss of 84 cents a share, or $2.8 billion, First Call says. It had already informed investors that sales fell 20% to 25% sequentially in the quarter ended Sept. 30. Demand for telecommunications equipment is likely to fall again in 2003, says Melanie Swan, an analyst with telecom consultancy RHK.

Analysts say Russo could still save Lucent -- but she's running out of time and money. She must cut expenses to break even with quarterly sales of $2 billion, instead of the current target of $2.5 billion, says Hasan Imam, an analyst with Thomas Weisel Partners. The stock price reflects how dire the situation is: Lucent hit a 52-week low of 55 cents on Oct. 11. Although it rebounded to 75 cents since, it's still down 91% from its 52-week high of $8.75. On Oct. 18, Lucent announced plans for a reverse split, designed to boost its stock price to between $15 and $25 and to prevent potential delisting from the New York Stock Exchange.

PUZZLED ANALYSTS. Understandably, bankruptcy speculation has swelled on Wall Street. Russo, who joined Lucent in January after leaving her post as president and chief operating officer at Eastman Kodak, needs to come up with a credible restructuring plan that will silence critics and instill hope in investors.

On the cost-cutting front, she still has plenty of fat to trim, analysts say. In fact, most of them are puzzled over why Lucent hasn't already cut costs further. Russo has announced plans to eliminate 25,000 jobs in 2002, which will reduce the workforce to 35,000 -- but that won't be enough. Russo will likely be forced to reduce staff by an additional 5,000 to 10,000 employees, say analysts.

Lucent may also be pressured into slashing what many consider a too-generous severance benefit of six months. Three months is more reasonable, according to Lehman Brothers. At the same time, Lucent needs to quickly close more money-losing divisions, such as parts of its long-haul business, whose products are used in inner-city communications networks. In addition, Lucent should cut capital spending at least in half, to below $400 million a year, Lehman adds. Considering the company's and the industry's financial straits, it's a wonder it's still spending anything at all.

HELP FROM A FRIEND? Yet no matter how draconian the cost-cutting gets, Lucent needs to raise more money to survive. With so many telecom assets flooding the marketplace, it's a buyer's market. Its wireless-access business, which makes routers that direct traffic along communications networks, could fetch $1.5 billion, Weisel's Imam estimates. Even a successful sale won't be enough to finance operations until Lucent can reach profitability, sometime over the next couple of years, and to pay $2 billion in convertible debt coming due in 2004.

What are some other options? Lucent could try to secure a credit line (oddly, it has none now) or perhaps get a cash infusion from one of its loyal customers, like Verizon. Counting its affiliates, the telecom contributes more than 20% of Lucent's sales, estimates Tal Liani, an analyst with Merrill Lynch. Already, it has reduced the pricing pressure it put on Lucent in the past two years, say some analysts. Since Lucent has built much of its networks, Verizon won't let it fail, says RHK's Swan. Both Verizon and Lucent declined to comment.

The biggest challenge on the financial front is an outstanding issue of nearly $2 billion in convertible bonds due in 2004. "If convertibles were to go away, that takes a big potential cash crunch away," says Lehman analyst Steve Levy. On a pre-reverse split basis, the stock needs to be trading at nearly $7.50 a share when the issue matures.

SHAREHOLDER REVOLT? Such a rebound is unlikely, however, putting Lucent in the unenviable position of having to pay off bondholders with either cash or stock. But using stock to pay off the debt could lead to 100% dilution of outstanding equity and require a shareholder vote. Shareholders most likely would revolt at the prospect, and it's unlikely Lucent would have the cash on hand to pay off bondholders. The convertible debt also stands in the way of negotiating a new credit line, which Lucent badly needs, because most credit agreements would probably prohibit Lucent from paying off the convertible issue with cash.

Lucent could lessen the convertible debt burden by retiring a part of it early -- for stock. As long as it doesn't dilute its equity by 20% or more, Lucent can issue more stock to buy the debt on the open market without a shareholder vote, according to UBS Warburg. And getting out from under this shadow is likely to boost the stock price. In the meantime, says company spokesperson Bill Price, "We believe we have sufficient liquidity."

Lucent still has some die-hard fans. Some analysts, including Sanford Bernstein's Paul Sagawa, who predicted the current telecom crisis, believe Russo can pull off a turnaround -- if the market for telecom equipment stops dropping. Indeed, some institutional investors are betting on it. Ronald Redfield, portfolio manager at Redfield, Blonsky & Co. says he holds Lucent shares and would advise any new clients to purchase the stock.

STEERING CLEAR. However, even he admits: "We've seen WorldCom and others claim there's plenty of liquidity, and then they go bankrupt within weeks. [Lucent is] doing what it needs to be doing, but there might be no possibility of getting out."

Clearly, Lucent is a high-risk investment until Russo shows progress in turning it around. Merrill Lynch and several other investment banks recommend avoiding the telecom equipment sector altogether. Says Stephen Kamman, an analyst with CIBC World Markets: Russo has "no room for error." Kharif writes for Business Week Online in Portland, Ore.